The Role of Information Technology in Modern Production: Complement or ...

The Role of Information Technology in Modern Production: Complement or Substitute to Other Inputs?

February, 1999

Lorin M. Hitt University of Pennsylvania, Wharton School

lhitt@wharton.upenn.edu 1318 Steinberg Hall-Dietrich Hall

Philadelphia, PA 19104

Eli M. Snir University of Pennsylvania, Wharton School

eli@grace.wharton.upenn.edu 1300 Steinberg Hall-Dietrich Hall

Philadelphia, PA 19104

We would like to thank Erik Brynjolfsson, Eric Clemons, Rachel Croson, David Croson, Paul Kleindorfer, Moti Levi, Hank Lucas, and seminar participants at the Wharton School and the Workshop on Information Systems and Economics for comments on earlier drafts of this paper. This research has been generously supported by the National Science Foundation (Grant IIS9733877). Incon Research, the Center for Survey Research, Computer Intelligence Infocorp and Informationweek provided or helped to collect essential data.

Currently Under Review for Management Science

The Role of Information Technology in Modern Production: Complement or Substitute to Other Inputs?

Abstract Previous work has shown that the economic impact of IT in general varies systematically with the way a firm is organized. This study investigates the effect of organizational factors on a particular aspect of the economics of IT: the substitution of IT capital for other inputs such as ordinary capital and labor. Much of the previous discussion of IT impact has focused on the substitution of IT for labor, yet much of the managerial literature has recently stressed the importance of finding complementarities between IT and other organizational practices. The ability to identify and leverage potential complements between IT and other factors may become increasingly important as IT investments are used less for simple cost reduction and more for creating customer value. Using firm level data for over 400 large firms, we find that a firm's ability to complement existing capital with IT investments is dependent on organizational factors. For "modern" organizations, exemplified by a decentralized organizational form, greater use of skilled staff, newer capital investments, and less inventory, IT and capital are complements, while for their "traditional" counterparts they are substitutes. Also, we find that all forms of organizations use IT as a net substitute for labor. As the price of information technology continues to decrease, we expect firms that have the ability to capitalize on complements with other inputs to become more profitable. Our results suggest that the ability to complement other investments with IT is not limited to certain sectors, but does depend on appropriate organizational design that includes adoption of modern practices.

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I. Introduction

The mechanisms by which information technology (IT) creates business value have been debated for over 40 years, starting with Leavitt and Whistler (1958). This paper examines one way in which IT creates value by complementing or substituting for other production inputs. For early IT applications, the value was generally viewed in terms of labor substitution; by using computers an organization could automate data storage and retrieval, conduct routine transaction processing and improve organizational communications. This reduces the need for file clerks, accountants and even middle managers, who traditionally performed those functions. Later, massive computerization of factories and equipment-intensive service operations (e.g., package delivery, air transport) created value by substituting capital. For example, computer-based scheduling and routing enabled transport vehicles to be used more effectively, reducing the need to expand fleets. Manufacturing automation systems boosted efficiency and utilization of existing facilities, permitting slower construction of new plants. Innovations in utilizing information for supply chain management have made possible substantial reductions in raw materials and finished goods inventories.

Recently, the emphasis in IT investment has shifted away from cost saving projects toward new ways of creating business value. Recent surveys of IT managers have revealed that cost saving is no longer the primary concern in their technology strategy. Enhancing other aspects of the business by improving time to market, quality, customer service and other intangible, revenue enhancing projects now appear to be the driver of new technology investments (Brynjolfsson and Hitt, 1996). However, as organizations have moved to pursue these strategies, researchers have increasingly recognized that IT investments must be accompanied by concurrent changes in other aspects of the organization (Hammer 1990; Davenport and Short 1990; Drucker 1988; Malone and Rockart 1991; Applegate, Cash and Mills 1988; Brynjolfsson and Mendelson 1993). The interaction between organizational design and the use of IT appears to be a critical part of IT investments. We examine this interaction by measuring the effect of organizational factors on the use of IT as a complement or substitute to other inputs.

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As IT investment is increasingly directed toward organizational transformation rather than simple automation, new computers may become less of a substitute for other production inputs. Multiskilled, empowered production workers may be less likely to be replaced by a new computer than a file clerk would have been; "intelligent" machines linked together in a computer integrated manufacturing system (CIM) may be more valuable than these machines operated in isolation. Instead of being substitutes for traditional factors of production, computers may increasingly be complements, at least in some types of organizations and for some types of factors.

Numerous authors have argued that computers are complements to skilled, empowered workers, customer focused strategies and flexible production processes (Bresnehan, 1997; Drucker 1988; Applegate, Cash and Mills 1988; Brynjolfsson and Hitt, 1996; Brynjolfsson and Hitt, 1998)1. Milgrom and Roberts (1990) have formalized and summarized many of these arguments in a mathematical model. They argue that computer-aided design and computer-controlled equipment are complementary to a set of organizational practices which include: faster product cycles, flexible machinery, short production runs, reduced inventories, empowered employees, highly skilled staff, and improved integration with suppliers and customers. This argument implies that, as the price of computers declines (as has happened for the last 30 years) organizations will increase investment not only in computers but in other complementary factors as well (e.g., flexible machinery, skilled workers). While the Milgrom and Roberts model is motivated by changes that are occurring in manufacturing, the types of organizational practices they describe are generally applicable across a wide range of organizations. Similarly, researchers are beginning to build links between the logic of complementarities and reengineering by offering new methods of productivity enhancement that rely heavily on both computers and organizational changes (Brynjolfsson, Renshaw, and Van Alstyne, 1996; Barua, Lee and Whinston, 1996).

These arguments raise the possibility that IT may not be a substitute but instead a complement to traditional production factors such as capital and labor in organizations that have flexible

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production, empowered workers, skilled staff, and low inventories. For purposes of discussion, we will term this collection of organizational characteristics "modern" organization, paralleling Milgrom and Roberts' description of modern manufacturing.

In this paper, we explore the hypothesis that modern organizations exhibit more complements between IT and traditional production factors, capital and labor. We use data on organizational characteristics and production inputs and outputs for over 400 large firms over 8 years (19871994) and factor input and output data for as many as 1000 firms. The results indicate little difference between the propensity of IT to substitute for labor between modern and traditional organizations, but an increased complementarity between IT and capital in modern organizations.

These results suggest that there are fundamental differences in the role of IT in different types of organizations. Moreover, the robust IT-labor substitution result suggests that even in applications where IT is skill enhancing, it may lead to a net reduction in total labor demand. These results shed new light on the relationship between IT investment and other organizational characteristics providing additional insight on the mechanism by which IT leads to higher productivity .

The remainder of this paper is structured as follows: Section II reviews previous literature on organizational implications of IT and IT-factor substitution, generating hypotheses to be tested; Section III introduces the data and measurement framework; Section IV contains the results, and we conclude with a summary and discussion in Section V.

II. Previous Literature

While the possible effects of IT on organizations are quite large and varied2 , in this section we focus specifically on arguments about how organizational practices can influence the degree of substitutability between IT and capital or IT and labor. We discuss previous work on the

1 IT has also figured prominently in arguments about the emergence of modern work practices (Ichnioski, Kochan,

Levine, Olson and Strauss,1996), skill-related wage inequality (Autor, Katz and Krueger, 1997; Berman Bound

and Griliches, 1994), and flexible production (MacDuffie, 1995). 2 A comprehensive discussion can be found in Lucas (1997) or other introductory texts.

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